This is the accessible text file for GAO report number GAO-04-849
entitled 'Credit Unions: Available Information Indicates No Compelling
Need for Secondary Capital' which was released on September 07, 2004.
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Report to Congressional Requesters:
August 2004:
CREDIT UNIONS:
Available Information Indicates No Compelling Need for Secondary
Capital:
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-849]:
GAO Highlights:
Highlights of GAO-04-849, a report to congressional requesters
Why GAO Did This Study:
Since the passage of the Credit Union Membership Access Act of 1998
(CUMAA), many in the credit union industry have sought legislative
changes to the net worth ratio central to prompt corrective action
(PCA). The current debate centers on the issue of allowing federally
insured credit unions to include additional forms of capital within the
definition of net worth. In light of the issues surrounding the debate,
GAO reviewed (1) the underlying concerns that have prompted the credit
union industry’s interest in making changes to the current capital
requirements, (2) the issues associated with the potential use of
secondary capital in all federally insured credit unions, and (3) the
issues associated with the potential use of risk-based capital in all
federally insured credit unions.
What GAO Found:
The credit union industry’s interest in making changes to the current
capital requirements for credit unions appears to be driven by three
primary concerns: (1) that restricting the definition of net worth
solely to retained earnings could trigger PCA actions due to conditions
beyond credit unions’ control; (2) that PCA in its present form acts as
a restraint on credit union growth; and (3) that PCA tripwires, or
triggers for corrective action, are too high given the conservative
risk profile of most credit unions. Despite these concerns, available
indicators suggest that the credit union industry has not been overly
constrained as a result of the implementation of PCA. As a group,
credit unions have maintained capital levels well above the level
needed to be considered well-capitalized and have grown at rates
exceeding those of other depository institutions during the three
calendar years that PCA has been in place for credit unions.
Allowing credit unions to use secondary capital instruments to meet
their regulatory net worth requirements would raise a number of issues
and concerns, with perhaps the most important issue centering on who
would purchase the secondary capital instruments. While outside
investors would provide market discipline, this would raise concerns
about the potential impact on the member-owned, cooperative structure
of credit unions. Inside investors, however, could impose less
discipline and raise systemic risk concerns if it resulted in a
situation where weaker credit unions could bring down stronger credit
unions due to secondary capital investments. Other issues relate to the
specific form of the capital instruments for credit unions. The credit
union industry itself appeared divided on the desirability or
appropriate structure of secondary capital instruments.
Conceptually, the use of risk-based capital to address the concerns
some in the credit union industry expressed about PCA is less
controversial. Though two risk-based capital proposals were put
forward, neither has garnered industry consensus and both lacked
details of key components upon which to base any assessment of their
merits. Risk-based capital is intended to reflect the unique risk
profile of individual financial institutions; however, there are other
factors that can affect an institution’s financial condition that are
not easily quantified. In recognition of the limitations of risk-based
capital systems, bank and thrift regulators use leverage and risk-based
capital requirements in tandem. GAO is aware that NCUA is constructing
a more detailed risk-based capital proposal that incorporates both
risk-based and leverage requirements; however due to the lack of
formalized details, GAO could not perform a meaningful assessment of
the proposal.
What GAO Recommends:
GAO observes that the general favorable economic climate for credit
unions experienced during the relatively short time that PCA has been
in place for credit unions precluded sufficient testing of the current
system of PCA and that additional time and greater experience are
needed to determine what, if any, changes to PCA are warranted. In
comments on this report, the National Credit Union Administration
(NCUA) concurred that a case for introducing secondary capital has not
been made but believed that adjustments to PCA were needed to make it
more fully risk based.
www.gao.gov/cgi-bin/getrpt?GAO-04-849.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Richard J. Hillman at
(202) 512-8678 or hillmanr@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Concerns about PCA Appear to Drive Industry Interest in Secondary
Capital:
Potential Use of Secondary Capital in the Credit Union Industry Poses
Many Unanswered Questions:
While Many View Risk-Based Capital as an Enhancement to PCA for Credit
Unions, Key Structural Issues Remain Unresolved:
Observations:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Definitions of Risk Portfolios and Weighted-Average Life
of an Investment, and a Risk-Based Standard Calculation Example:
Appendix III: Items in Use by NCUA in Developing Its Risk-Based Capital
Proposal:
Appendix IV: Comments from the National Credit Union Administration:
Appendix V: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Acknowledgments:
Tables:
Table 1: Summary of PCA Capital Requirements for Credit Unions:
Table 2: NAFCU Board's Seven Principles for a Viable Alternative Capital
Model:
Table 3: Risk Portfolios Defined:
Table 4: Weighted-Average Life of Investments:
Table 5: Example of the Standard Calculation of the Risk-Based Net Worth
Requirement:
Figures:
Figure 1: Federally Insured Credit Unions' Total Shares, Total Assets,
and Capital Ratios, 1994-2003:
Figure 2: Asset Growth of Other Depository Institutions Compared with
Credit Unions, 1994-2003:
Figure 3: Summary of FDICIA Capital Categories and Ratio Requirements:
Abbreviations:
CEO: chief executive officer:
CRA: Community Reinvestment Act:
CUMAA: Credit Union Membership Access Act of 1998:
CUNA: Credit Union National Association:
FCUA: Federal Credit Union Act:
FDIC: Federal Deposit Insurance Corporation:
FDICIA: Federal Deposit Insurance Corporation Improvement Act of 1991:
GAAP: generally accepted accounting principles:
NAFCU: National Association of Federal Credit Unions:
NASCUS: National Association of State Credit Union Supervisors:
NCUA: National Credit Union Administration:
NCUSIF: National Credit Union Share Insurance Fund:
NWRP: Net Worth Restoration Plan:
PCA: prompt corrective action:
RBNW: risk-based net worth:
ROAA: return on average assets:
Treasury: Department of the Treasury:
Letter August 6, 2004:
The Honorable Michael G. Oxley:
Chairman:
The Honorable Barney Frank:
Ranking Minority Member:
Committee on Financial Services:
House of Representatives:
The Honorable Brad Sherman:
House of Representatives:
Credit unions, which have approximately 82 million members across the
United States, historically have occupied a unique niche among
depository institutions.[Footnote 1] Credit unions are member-owned
cooperatives that are exempt from federal income taxes. They do not
issue capital stock; rather, they are not-for-profit entities that
build capital by retaining earnings. Recent debate about and support
for changes to the existing capital requirements for credit unions--
which establishes the percentage of net worth to total assets that they
must maintain--has raised concerns about potential safety and soundness
implications. These implications derive from the many important
purposes a depository institution's capital serves. From a regulatory
perspective, capital acts as a buffer against unexpected operating
losses or other adverse financial results. From a depository
institution's perspective, capital serves as a basis to generate long-
term growth. Capital is also commonly viewed as a measure of financial
strength.
Prior to 1998, the National Credit Union Administration (NCUA), which
regulates federally chartered credit unions and certain aspects of
federally insured state-chartered credit unions, did not impose any net
worth requirement on federally insured credit unions.[Footnote 2]
Instead, as noted by NCUA, Section 116 of the Federal Credit Union Act
(FCUA) required credit unions to make a periodic reserve transfer until
reserves reached 6 percent of risk-assets (10 percent for credit unions
with under $5 million in assets). Then in 1998, the Credit Union
Membership Access Act (CUMAA) established a capital-based supervisory
framework called prompt corrective action (PCA) that requires NCUA to
classify federally insured credit unions into five categories--well-
capitalized, adequately capitalized, undercapitalized, significantly
undercapitalized, and critically undercapitalized--based on net-worth-
to-total-assets ratios. Under PCA, credit unions that are less than
well-capitalized must take actions prescribed by statute and
discretionary actions developed by NCUA based on the institutions'
capitalization category.[Footnote 3]
Since the implementation of PCA for credit unions, some sectors of the
credit union industry have been calling for changes to the capital
requirements for credit unions. The changes called for generally
include (1) amending the definition of net worth to include alternative
forms of capital, such as unsecured subordinated debt instruments--
known as secondary capital instruments; (2) moving to risk-based
capital standards; and (3) some combination of the changes discussed
above.[Footnote 4]
As agreed, you asked us to describe (1) the underlying concerns that
have prompted the credit union industry's interest in making changes to
the current capital requirements, (2) the issues associated with the
potential use of secondary capital in all federally insured credit
unions, and (3) the issues associated with the potential use of risk-
based capital in all federally insured credit unions.
To identify and describe concerns regarding the current capital
requirements for credit unions, we interviewed credit union industry
groups, several credit union chief executive officers, credit union
regulators and two banking regulators. Additionally, in these
interviews we gathered information on the issues and concerns
associated with the potential use of secondary capital and risk-based
capital by credit unions. We also conducted a literature search to
identify studies on the potential use of secondary capital by credit
unions and spoke with academics and other industry observers. Appendix
I provides additional details on our scope and methodology. We are
aware that NCUA is constructing a more detailed risk-based capital
proposal that incorporates both risk-based and leverage requirements;
however due to the lack of formalized details, we could not perform a
meaningful assessment of the proposal. We conducted our work in
Washington, D.C., from November 2003 through July 2004 in accordance
with generally accepted government auditing standards.
Results in Brief:
The credit union industry's interest in making changes to the current
capital requirements for credit unions appears to be driven by three
primary concerns: (1) that restricting the definition of net worth
solely to retained earnings could trigger PCA actions due to conditions
beyond credit unions' control; (2) that PCA in its present form acts as
a restraint on credit union growth; and (3) that PCA tripwires, or
triggers for corrective action, are too high given the conservative
risk profile of most credit unions. First, the argument most often
advanced for allowing all federally insured credit unions to use
additional forms of capital is that events such as a rapid inflow of
funds, as occurred in recent years because of adverse conditions in
investment markets, might result in otherwise well-managed credit
unions experiencing a rate of share (deposit) growth that exceeds their
ability to accumulate retained earnings. Consequently, this would
decrease credit unions' net worth ratio and trigger PCA actions.
However, we did not find evidence that the inflow of member share
deposits resulted in widespread net worth problems for federally
insured credit unions during the period that PCA has been in place.
Second, some industry representatives have argued that PCA acts as a
restraint on growth because credit unions are not able to retain
earnings quickly enough to avoid a decline in net worth ratios during
periods of sustained growth. While PCA is intended to curb aggressive
growth, our analysis of credit union and bank data indicates that
credit unions have been able to grow at a higher rate than banks during
the 3 years that PCA has been in place for credit unions. Third, some
industry representatives have also contended that PCA trigger points
for credit unions are higher than for banks and thrifts despite the
generally more conservative risk profile of credit unions. It should be
noted that Congress established the capital standards to take into
account that credit unions do not issue capital stock and must rely on
retained earnings to build net worth, which necessarily takes time.
Moreover, the Department of the Treasury (Treasury) stated that
Congress established the leverage capital level 2 percentage points
higher than banks and thrifts because 1 percent of a credit union's
capital is deposited in the National Credit Union Share Insurance Fund
(NCUSIF) and another 1 percent of the typical credit union's capital is
invested in a corporate credit union.
The credit union industry itself has expressed widely divergent
viewpoints on the desirability of additional forms of capital for all
federally insured credit unions, with perhaps the most important issue
centering on who would purchase the secondary capital instruments.
Allowing investors outside of the credit union industry to hold the
instruments would bring increased market discipline, but there are
concerns that this would be more costly than the usual sources of funds
and change the member-owned, cooperative nature of the credit union
industry. Alternatively, allowing investors from within the industry
may alleviate these concerns; however, in-system investors could impose
less discipline than out-of-system investors, raising concerns about
investor protection--adequacy of disclosure regarding the uninsured,
subordinated status of the investment--and the potential that a weaker
credit union could pull down a stronger one (systemic risk) because the
investment of one credit union would be treated as the capital of
another. Other concerns relate to the specific form of the capital
instruments, and how they would be incorporated into the regulatory net
worth requirement for credit unions. We could not identify proposals on
the use of secondary capital by credit unions that were specific enough
to facilitate our assessment of these key issues. While two types of
specialized credit unions--low income and corporate--can currently use
alternative capital instruments to meet their regulatory capital
requirements, their experiences are too limited or unique for
application to the bulk of the industry. One industry group, however,
has developed a list of principles, or minimum set of criteria, to
consider for any proposal.
A number of key structural issues regarding the potential use of risk-
based capital for all credit unions remain unresolved, including (1)
the extent to which risk-based ratios would be used to augment, versus
replace, the current PCA net worth (leverage) requirements; and (2) how
key risk components and weights that are appropriate to the unique
characteristics of credit unions would be defined. In contrast to most
credit unions, all banks and thrifts are required to meet both a
leverage ratio and a risk-based capital ratio in order to be
"adequately capitalized." Bank and thrift regulators recognized the
limitations of a solely risk-based capital requirement and continued
the leverage requirements to address factors a risk-based ratio does
not address but that can affect an institution's financial condition,
such as liquidity and operational risks. Under CUMAA, the few credit
unions that must meet risk-based net worth requirements are called
"complex" credit unions, generally those with total assets at the end
of a quarter exceeding $10 million and with a risk-based net worth
calculation exceeding 6 percent; they represent approximately 8 percent
of all federally insured credit unions as of December 2003. Though a
credit union trade association has put forward two risk-based capital
proposals, neither has garnered industry consensus. Moreover, each
proposal lacked key components such as a clear definition of risk
assets, risk weights, and asset classifications appropriate for credit
unions. As a result, these proposals did not contain sufficient details
upon which to assess their merits. In addition, NCUA officials told us
they are developing, but have not yet finalized, a risk-based capital
proposal to augment the current PCA for all credit unions that they
believe acknowledges the unique nature of credit unions and
incorporates the relevant and material risks credit unions face.
We provided a draft of this report to the Chairman of the National
Credit Union Administration and the Secretary of the Treasury for
review and comment. We received written comments from NCUA that are
reprinted in appendix IV. NCUA agreed with this report's assessment
that a case for secondary capital has not been made due to key
unresolved issues and the lack of industry consensus on the need for
and appropriate structure of secondary capital instruments. However,
NCUA stated that its experience gained to date with the PCA system for
federally insured credit unions indicates a need to make adjustments to
better achieve its overall objectives. Specifically, NCUA stated that
these adjustments should move PCA to a more fully risk-based system,
with a lower leverage ratio (ratio of net worth to total assets).
However, we believe that the generally favorable economic climate for
credit unions experienced during the relatively short time that PCA has
been in place for credit unions precluded sufficient testing of the
current system of PCA for credit unions to determine if significant
changes, such as that proposed by NCUA, are warranted. In addition, GAO
believes that any proposal to move to a more risk-based system should
provide for both risk-based and meaningful leverage capital
requirements to work in tandem.
Background:
The current U.S. bank risk-based capital regulations implement the 1988
Basel Accord on risk-based capital.[Footnote 5] The Basel Accord
established the widespread use of capital ratios that bank and thrift
regulators could use as a starting point for assessing the financial
condition--that is, safety and soundness--of internationally active
banks and thrifts. In the United States, U.S. bank regulators applied
the Basel Accord to all banks, rather than just internationally active
ones. In 1991, GAO recommended a tripwire approach--incorporating
capital and safety and soundness standards, or levels at which
supervisory actions would be triggered--based on our findings that
regulatory discretion and a common philosophy of trying to resolve the
problems of troubled institutions informally and cooperatively resulted
in enforcement actions that were neither timely nor forceful enough to
prevent or minimize losses to the deposit insurance fund.[Footnote 6]
Moreover, acting in response to the large number of bank and thrift
failures in the late 1980s and early 1990s, Congress enacted the
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA),
which included a capital-based regulatory structure known as
PCA.[Footnote 7] Specifically, FDICIA categorizes depository
institutions into five classifications on the basis of their capital
levels and imposes increasingly more severe restrictions and
supervisory actions as an institution's capital level deteriorates.
CUMAA required NCUA to adopt a system of PCA comparable with that of
FDICIA for use on federally insured credit unions, which NCUA initially
implemented in 2000.[Footnote 8] CUMAA defined the net worth ratio for
PCA purposes as net worth to total assets.[Footnote 9] Under CUMAA, net
worth is defined as the retained earnings balance of the credit union
at quarter end, as determined under generally accepted accounting
principles (GAAP).[Footnote 10] NCUA regulations provide four
alternative methods that credit unions can use to calculate total
assets for use in the net worth ratio: (1) average of quarter-end
balances of the current and three preceding calendar quarters, (2)
average of month-end balances over the three calendar months of the
calendar quarter, (3) average daily balance over the calendar quarter,
or (4) quarter-end balance of the calendar quarter as reported on the
credit union's call report.[Footnote 11] NCUA regulations state that
for each quarter, a credit union must elect a measure of total assets
from these four alternatives to apply for all PCA purposes, except for
the risk-based net worth requirement.[Footnote 12]
CUMAA prescribes three principal components of the PCA system for
credit unions: (1) a comprehensive framework of actions, including
actions prescribed by statute and discretionary actions to be developed
by NCUA, for credit unions that are less than well-capitalized; (2) an
alternative system of PCA to be developed for credit unions that NCUA
defines as "new"; and (3) a risk-based net worth requirement to apply
to credit unions that NCUA defines as "complex."[Footnote 13] Table 1
summarizes the PCA capital requirements for regular and complex credit
unions.
Table 1: Summary of PCA Capital Requirements for Credit Unions:
PCA category: Well-capitalized;
Net worth ratio for all credit unions (percent): > 7;
Risk-based ratio for "complex" credit unions: And, > applicable risk-
based net worth (RBNW) requirement.
PCA category: Adequately capitalized;
Net worth ratio for all credit unions (percent): 6 to 6.99;
Risk-based ratio for "complex" credit unions: And, > applicable RBNW
requirement.
PCA category: Undercapitalized;
Net worth ratio for all credit unions (percent): 4 to 5.99;
Risk-based ratio for "complex" credit unions: Or, < applicable RBNW
requirement.
PCA category: Significantly undercapitalized;
Net worth ratio for all credit unions (percent): 2 to 3.99, or less
than 5 and fails to submit or implement a net worth restoration plan;
Risk-based ratio for "complex" credit unions: Not applicable.
PCA category: Critically undercapitalized;
Net worth ratio for all credit unions (percent): < 2;
Risk-based ratio for "complex" credit unions: Not applicable.
Source: NCUA Rules and Regulations, 12 C.F.R. §702.102.
[End of table]
CUMAA imposes up to four mandatory supervisory actions--an earnings
transfer, submission of an acceptable net worth restoration plan, a
restriction on asset growth, and a restriction on member business
lending--depending on a credit union's capital classification, as
determined by net worth ratios. Credit unions that are not well-
capitalized are required to take an earnings transfer.[Footnote 14]
Credit unions that are undercapitalized, significantly
undercapitalized, or critically undercapitalized are subject to all
four actions. In addition, CUMAA requires NCUA to appoint a conservator
or liquidation agent within 90 days of a credit union becoming
critically undercapitalized unless the NCUA Board of Directors
determines that other action would better achieve PCA's purpose.
Pursuant to CUMAA, NCUA also developed discretionary supervisory
actions, such as the dismissal of officers or directors of an
undercapitalized credit union, to complement the prescribed actions
under the PCA program.
While CUMAA required NCUA to implement a system of capital-based
tripwires, capital-based safeguards of insurance funds are inherently
limited because capital does not typically show a decline until an
institution has experienced substantial deterioration in other
components of its operations and finances. Deterioration in an
institution's internal controls, asset quality, and earnings can occur
years before capital is adversely affected. Financial regulators
recognize that, though essential, a capital requirement is only one of
a larger set of prudential tools used to protect customers and ensure
the stability of financial markets they regulate. For depository
institutions, the key or critical tool that financial regulators use to
ensure the adequacy of an institution's capital levels and its safety
and soundness is the on-site examination process.
Concerns about PCA Appear to Drive Industry Interest in Secondary
Capital:
The credit union industry's recent interest in using alternative forms
of capital appears to be associated primarily with three concerns about
PCA for credit unions. First, several credit union officials argued
that secondary capital or other alternatives were needed, given
concerns that credit unions might trigger PCA restrictions because of
rapid inflows of deposits due to investors' "flight to safety";
however, we have not found widespread evidence to support these
concerns. To assist credit unions that fall marginally below
"adequately capitalized" primarily because asset growth has outstripped
income growth, NCUA proposed the use of an abbreviated net worth
restoration (NWRP) plan. According to an NCUA official, the proposed
rule was not pursued further because it was considered too complicated,
would only benefit a very small number of credit unions, and did not
appear to provide material relief. Second, other credit union officials
contended that PCA acts as a restraint on credit union growth. Our
analysis of credit union and bank data indicates that credit unions
have been growing faster than banks in the 3 years credit union PCA has
been in effect. Finally, several credit union officials are concerned
that the PCA tripwires for credit unions are too high, given the
conservative risk profile of most credit unions. It should be noted
that, according to Treasury, Congress established the capital level 2
percentage points higher because 1 percent of a credit union's capital
is deposited in NCUSIF and another 1 percent of the typical credit
union's capital is invested in a corporate credit union.[Footnote 15]
"Flight to Safety" Raised Concerns about PCA, Although Net Worth Ratios
Generally Remained above Well-Capitalized Levels:
As investors sought high-quality (that is, safe) investments due to
weak performance by the stock and other investment markets in the early
2000s, credit unions experienced significant growth in member share
deposits. Several credit union industry officials expressed concern
that this inflow of new shares into credit unions might dilute net
worth ratios, thus triggering net worth restoration plans and other
supervisory actions under PCA.
To assist credit unions that fall marginally below "adequately
capitalized" primarily because asset growth outstrips income growth,
NCUA introduced the concept of an abbreviated NWRP in June
2002.[Footnote 16] While no specific proposal was introduced, the NCUA
board invited public comment on the concept of what was then referred
to as "safe harbor" approval of a NWRP--that is, notice of certain
criteria established by regulation that, when met, will ensure
approval.
In November 2002, NCUA put forth a proposed rule and request for public
comment on allowing the use of abbreviated NWRP--which NCUA referred to
as a first-tier NWRP--by qualifying federally insured credit unions
whose net worth ratio declined marginally below the adequately
capitalized threshold (6 percent) because growth in assets outpaced
growth in net worth.[Footnote 17] Under the proposal, a credit union
would have been eligible to file an abbreviated NWRP if it satisfied
three criteria: historical net worth, performance, and growth.[Footnote
18]
There were three principal differences between the content requirement
of a standard NWRP and the abbreviated NWRP proposed by NCUA. First,
the proposed abbreviated NWRP would require only 4 quarters of pro
forma projections of total assets, shares and deposits, and return on
average assets, while the standard NWRP required complete pro forma
financial statements covering a minimum of 2 years. Second, the
abbreviated NWRP would not require a credit union to specify what steps
it would take to meet its schedule of quarterly net worth targets,
which is required for a standard NWRP. Finally, a standard NWRP
requires those steps to extend beyond the term of the plan to ensure
that the credit union remains at least adequately capitalized for 4
consecutive quarters thereafter. In contrast, the proposed abbreviated
NWRP did not address the credit union's net worth after the end of the
term of the plan. NCUA's proposed rule also detailed the criteria for
approval of the abbreviated NWRP and the circumstances in which a
credit union that would otherwise be eligible to file an abbreviated
NWRP would have been required to file a standard NWRP instead.
According to an NCUA official, the proposed rule was not pursued
further because it was considered too complicated, would benefit only a
very small number of credit unions, and did not appear it would provide
material relief since some form of NWRP (albeit somewhat abbreviated)
was still required by statute. NCUA officials stated that the credit
union industry supported the proposal for an abbreviated NWRP but the
credit union industry was advocating a proposal that would be
automatically approved if it met a fixed set of objective criteria.
However, NCUA officials explained that CUMAA requires a case-by-case
determination by NCUA that a plan "is based on realistic assumptions
and is likely to succeed in restoring the net worth of the credit
union."
Although NCUA's proposal to assist certain credit unions that fall
marginally below "adequately capitalized" was not pursued further, we
found that despite a recent inflow of member share deposits, the credit
union industry as a whole has been able to maintain net worth ratios
well above the PCA threshold for well-capitalized credit unions.
Moreover, current data suggest that the "flight to safety" may be over,
as investors appear to be returning to the investment markets. Figure 1
illustrates that during the period that PCA has been in place for
credit unions (2001-2003), the net worth ratios for federally insured
credit unions dropped somewhat initially but stabilized at the close of
2003.
Figure 1: Federally Insured Credit Unions' Total Shares, Total Assets,
and Capital Ratios, 1994-2003:
[See PDF for image]
[End of figure]
Note: We analyzed the NCUA Form 5300 database, found at [Hyperlink,
http://www.ncua.gov/data/FOIA/foia.html].
Groups such as the National Association of State Credit Union
Supervisors (NASCUS) and several credit union chief executive officers
(CEO) told us that that the combination of PCA requirements and
members' flight to safety from the markets could force both fast-
growing credit unions and small to midsize credit unions to choose
between (1) refusing deposits, (2) reducing services to members in
order to retard the growth of assets, (3) converting to a savings and
loan or community bank, or (4) merging with another credit union. While
some of the larger credit union CEOs with whom we spoke stated that PCA
is not causing capital constraints currently, they told us the
potential exists for share growth to outstrip their ability to retain
earnings, thus triggering net worth restoration plans and other
supervisory actions under PCA. On the other hand, according to some
CEOs of small and midsize credit unions, these constraints are
affecting them currently. While the constraints noted above may have
occurred to some extent in a limited number of credit unions, we did
not find evidence of widespread net worth problems for federally
insured credit unions during the period PCA has been in place.
Moreover, as of December 2003, less than 3 percent of federally insured
credit unions have reported a net worth ratio below the well-
capitalized threshold.
PCA Cited as a Restraint on Growth, Although Credit Unions Have Had
Stronger Growth Rates Than Banks and Thrifts:
Some credit union industry officials have indicated that the current
credit union PCA system acts as a restraint on credit union growth,
because any additional new member shares (deposits) would increase
their assets and correspondingly reduce their net worth ratios. While
most credit unions have been well-capitalized during the period that
PCA has been in place, some industry officials have suggested that the
capital constraints it imposes will become increasingly difficult to
manage, forcing credit unions to turn away deposits so as not to dilute
or decrease their net worth ratios. It should be noted that PCA was
intended to curb aggressive growth, since uncontrolled growth was one
of the common attributes of thrifts and banks that failed during the
banking crisis of the late 1980s and early 1990s.
Credit union industry officials, including NCUA, have stated that some
credit unions have had to reduce their services to members in an effort
to satisfy PCA requirements. NCUA officials told us credit unions that
have decreased services to their members have done so as part of net
worth restoration plans. However, NCUA officials told us they would
have no way of determining the number of credit unions considering
decreasing services in an effort to prevent being subject to regulatory
actions by NCUA. We have not found any evidence that federally insured
credit unions are limiting their services to accommodate a rapidly
growing deposit base. Moreover, active asset management is a major
component of the operations of any financial institution. Credit union
managers are expected to manage the growth of their institutions so
that an influx of member deposits would not cause the credit union to
become subject to PCA.
Despite the concerns about PCA acting as a constraint against asset
growth, credit unions have grown at a higher rate than banks and
thrifts during the period that PCA has been in place for credit unions
(see fig. 2). This was particularly the case in 2001, the first full
calendar year in which PCA was in place for credit unions. In that
year, credit unions achieved an asset growth rate of more than 14
percent, compared with an approximate growth rate of 6 percent for
other depository institutions. The disparity in growth rates narrowed
in 2002 and 2003.
Figure 2: Asset Growth of Other Depository Institutions Compared with
Credit Unions, 1994-2003:
[See PDF for image]
[End of figure]
Industry Has Contended That PCA Triggers Are Too High:
The credit union industry has consistently criticized PCA triggers
(that is, capital thresholds) as being too high. Some credit union
officials have noted that PCA encourages credit union managers to hold
more capital than is necessary, which does not allow them to maximize
shareholder value. In addition, they said that PCA tripwires for credit
unions are higher than those of banks and thrifts despite the more
conservative risk profile of credit unions.
Banks and thrifts are required to meet two capital requirements in
order to be adequately capitalized: (1) a minimum tier 1 leverage
ratio--that is a minimum ratio of total capital to total assets, which
is generally 4 percent of tier 1 capital; and (2) a risk-based capital
ratio of 8 percent capital to risk-weighted assets.[Footnote 19] Under
CUMAA's net worth requirements, federally insured credit unions must
maintain at least 6 percent net worth to total assets to be considered
adequately capitalized. This exceeds the 4 percent tier 1 leverage
ratio applicable for banks and thrifts (and is statutory, as opposed to
regulatory). In its 2001 report, Treasury stated that Congress
determined that a higher ratio was appropriate because credit unions
cannot quickly issue capital stock to raise their net worth as soon as
a financial need arises. Instead, credit unions must rely on retained
earnings to build net worth, which necessarily takes time. Moreover,
Treasury stated that Congress established the capital level 2
percentage points higher, a level recommended by Treasury in its 1997
report on credit unions, because 1 percent of a credit union's capital
is deposited in NCUSIF and another 1 percent of the typical credit
union's capital is invested in a corporate credit union.[Footnote 20]
Effective July 3, 2003, a federally insured credit union is allowed to
invest up to 2 percent of its assets in any one corporate credit union
and, in the aggregate, up to 4 percent of its assets in multiple
corporate credit unions.[Footnote 21]
Potential Use of Secondary Capital in the Credit Union Industry Poses
Many Unanswered Questions:
Though some in the credit union industry seek use of alternative forms
of capital, little information exists that would allow us to assess the
implications of using these instruments. We found that the credit union
industry lacks consensus on the desirability of these instruments, with
one of the key issues in the current debate over secondary capital
centered on who would purchase these instruments and their resulting
impact on the unique nature of credit unions--member-owned, not-for-
profit cooperatives. Also, we could not identify a definitive proposal
that specifically addressed other critical issues relating to the use
of secondary capital instruments, such as pricing and market demand.
While low income credit unions are allowed to use secondary capital
instruments and corporate credit unions are allowed to use secondary
capital instruments and count it toward their net worth requirements,
their experiences are too narrow to offer insight into the value of
such an instrument for all federally insured credit unions.[Footnote
22] However, one industry group has developed a list of principles, or
minimum set of criteria, to consider for any proposal.
Industry and Other Experts Disagree on the Merits of Using Secondary
Capital:
The credit union industry is divided on the merits and potential
effects of using alternative capital. Credit union industry officials
have expressed concerns that credit unions may find their rate of share
(deposit) growth exceeding their ability to accumulate retained
earnings, triggering net worth restoration plans and other supervisory
actions under PCA. According to one trade association, the Credit Union
National Association (CUNA), building net worth through earnings
retention is a time-consuming process, and being able to use
alternative capital instruments would allow a credit union to quickly
build its capital levels. Additionally, some credit union officials
believe that the current credit union capital system encourages
managers to overcapitalize their credit unions (that is, hold excessive
capital), which is not always the best alternative for financial
institutions. Some officials have stated that secondary capital would
allow credit union managers the flexibility to be more proactive in
managing their capital.
One credit union CEO, whose institution is one of the largest federally
insured credit unions, stated that three of the five largest federally
chartered credit unions were against allowing credit unions to acquire
secondary capital. He countered arguments for changing PCA by citing
his credit union's experience with a dramatic influx in shares 2 years
ago. He noted the influx did not trigger PCA because his institution's
capital was aggressively managed. The CEO added that the dividends paid
to the credit union's members, along with other services, were not
limited or reduced as a result of this aggressive management. He
explained that the excess capital (which was built over time through
returns on investments at higher interest rates) in concert with
diligent capital management kept the credit union from triggering PCA.
Industry Debate Centers around Key Issue of Outside Versus In-System
Investors:
Debate over secondary capital centers around who should be allowed to
purchase these instruments. Some in the credit union industry argue
that allowing outsiders to invest in the credit union industry would
increase market discipline, but there are concerns that outside
investment would be more costly and change the structure of the credit
union industry. Opponents of secondary capital suggest that allowing
voting, or even nonvoting, secondary capital from investors outside of
the credit union industry would dilute the ownership structure of
credit unions--not-for-profit, member-owned cooperatives. For example,
one credit union CEO asserts that secondary capital would allow outside
investors "a place at the table," whether the subordinated debt
instruments carry voting or nonvoting rights. He explained that the
outside investors could demand returns on investments through changes
in interest rates or another form of return, or a right of first
refusal if the credit union should ever adopt a for-profit model. Other
credit union managers, including those in favor of secondary capital,
told us that if done carelessly, secondary capital for credit unions
could be disastrous; however, they will continue to promote the use of
secondary capital provided it does not change the credit union's
ownership rights.
To alleviate these concerns, others suggest allowing investors from
within the industry (in-system investors). This approach, however,
raises concerns about investor protection and other systemic risks.
Moreover, in-system investors could impose less discipline than out-of-
system investors. According to one academic expert, the credit union
industry is divided on the topic of alternative capital; the academic
stated that at least 55 percent of credit unions want to avoid the
capital markets, while the remainder would be more open to entering the
capital markets and become increasingly banklike. He cautioned that
alternative capital should not be used to sustain credit unions that
were not already solvent. He explained that secondary capital from
investors within the credit union system--that is, credit union members
and other credit unions--might introduce systemic risk, wherein the
risks of the issuing credit union were inherently spread to the credit
union holding the debt instrument. For example, if Credit Union A
purchased subordinated debt from Credit Union B and Credit Union B
failed and was forced to liquidate its assets, Credit Union A would
then be financially affected, possibly resulting in two failed credit
unions.
Additionally, some officials in the credit union industry suggested
that with appropriate disclosure, individual credit union members could
invest in secondary capital instruments offered by credit unions.
However, even with these disclosures (recognizing that alternative
capital instruments are uninsured, nonvoting, and subordinated to other
shares), it is possible that credit union members may not fully
understand and appreciate the subordinated nature of their investments.
Industry Has Not Produced Detailed Proposals; Other Literature on
Secondary Capital Also Limited:
We identified one proposal and one academic study that suggest how
secondary capital could be utilized by all federally insured credit
unions; however, these lacked sufficient detail and did not address
critical issues. Specifically, the proposal and academic study did not
address the specific form of the capital instruments, criteria
governing its issuance (including how it would be incorporated into the
regulatory net worth requirement for credit unions), market viability
and demand (including in-system or out-of-system investors), and
pricing analysis to effectively discuss its potential benefits and
implications. As a result of the lack of detail, we were unable to
fully assess the issues associated with the potential use of secondary
capital by all credit unions.
The secondary capital proposal--"Capital Notes"--was developed by the
CUNA Mutual Group, a company that offers health insurance and financial
services to credit unions. CUNA Mutual Group believes the Capital Notes
program, slated for two phases, could help credit unions meet their
capital needs. CUNA Mutual Group is piloting this secondary capital
mechanism to low income credit unions, which are already permitted
under NCUA regulations to count secondary capital toward their PCA
requirements. The Capital Notes program allows low income credit unions
to issue unrated subordinated debt in a private placement with flexible
terms and rates.[Footnote 23] CUNA Mutual Group purchases the notes
issued by the low income credit unions to hold in its investment
portfolio.
According to CUNA Mutual Group, if the PCA definition of net worth is
changed to include secondary capital, the subsequent planned phase of
the Capital Notes program will allow all federally insured credit
unions to issue unrated, unsecured notes that would be purchased by a
trust. The trust would then go through a ratings process and issue its
own notes that institutional investors such as corporate credit unions,
CUNA Mutual Group, and other insurance companies could purchase. CUNA
Mutual Group representatives stated that corporate credit unions would
then purchase the highest-rated notes and CUNA Mutual Group, or other
insurance companies, would most likely hold the lower-rated or first-
loss notes. According to CUNA Mutual Group, the advantages of its
Capital Notes program are that it:
* allows fast-growing and low-capitalized credit unions to secure
additional needed capital;
* provides additional protection to NCUSIF, the share insurance fund;
* allows credit unions access to capital sources already available to
other depository institutions, such as banks;
* maintains members' governance rights; and:
* avoids potential abuses in sales of the notes by restricting
purchasers to qualified (institutional) investors.
Because the Capital Notes program began its pilot phase in December
2003, insufficient time has passed to allow for an assessment of the
effectiveness of the program for low income credit unions. In addition,
the motivation of secondary capital investors in low income credit
unions is likely significantly different from that of investors in
other federally insured credit unions. Consequently, the pricing
analysis, market viability, and demand (in-system as well as out-of-
system) of the first phase of Capital Notes may not be applicable to
the proposed second phase of the program.
We identified an academic study regarding the potential use of
alternative capital instruments by credit unions.[Footnote 24] This
study, issued by the Filene Research Institute and the Center for
Credit Union Research, concluded that allowing credit unions to sell
subordinated debt to parties outside of the credit union industry to
meet their capital requirements could provide the following advantages:
* In terms of market discipline, the higher interest costs associated
with debt of riskier credit unions would reduce the temptation of
excessive risk taking by credit union managers and would send a
forward-looking signal to regulators if credit unions' risk taking
increased.
* In terms of transparency and disclosure, marketing of subordinated
debt, directly or via a pool arrangement, would require increased
transparency and disclosure about the condition of credit unions.
* In terms of maintaining a larger cushion for the share insurance
fund, the holders of subordinated debt would be compensated only after
NCUSIF was fully compensated out of sales of existing assets, thereby
reducing the risk to the insurance fund.
* In terms of increasing the incentives for prompt action by
supervisors, holders of subordinated debt would encourage regulators to
act promptly if credit unions became excessively risky or troubled.
However, while presenting a framework for using secondary capital, the
authors of the study did not provide a specific proposal. In addition,
they did not address market demand for secondary capital, pricing or
the ultimate cost of these instruments to credit unions or assess the
impact of the external subordinated debt holders on the member-owned
and member-operated structure of credit unions.
Few Credit Unions Have Experience with Secondary Capital Instruments:
NCUA first authorized the issuance of secondary capital instruments by
low income credit unions in 1996.[Footnote 25] According to NCUA, it
granted the authority in recognition of the special needs of these
credit unions to raise capital from sources outside of their low income
communities. Under NCUA regulations, credit unions with a low income
designation can (1) receive nonnatural person, nonmember deposits that
are not NCUSIF-insured; (2) offer uninsured secondary capital accounts
and include these accounts on the credit union's balance sheet for
accounting purposes; and (3) include these secondary capital accounts
in the credit union's net worth for PCA purposes.[Footnote 26] However,
investment in low income credit unions does not offer a template for
the industry because the motivations of secondary capital investors in
low income credit unions may be different from investors in other
federally insured credit unions. For example, banks may obtain credit
under the Community Reinvestment Act (CRA) for their investment in low
income credit unions.[Footnote 27] In addition, many foundations and
philanthropic organizations also are involved in providing secondary
capital to low income credit unions in an effort to ensure that the
credit unions are able to provide needed financial services to areas
traditionally underserved by mainstream financial institutions.
Moreover, as of December 31, 2003, less than 6 percent of all low
income credit unions had secondary capital accounts. Additionally, low
income credit unions that had secondary capital accounts represented
less than 1 percent of all federally insured credit unions. Thus, in
addition to the different incentives for investment, the limited
experience of low income credit unions with secondary capital
instruments also provides little insight into the potential market
demand and pricing of secondary capital instruments for all federally
insured credit unions.
Corporate credit unions--whose members are credit unions, not
individuals--also can issue forms of secondary capital.[Footnote 28]
According to NCUA, corporate credit unions have been allowed to use
secondary capital instruments to meet their regulatory capital
requirements since 1992 in recognition that the ability of corporate
credit unions to build capital is limited by the combined effects of
(1) conservative investment standards imposed by NCUA and (2) the
competitive markets in which corporate credit unions vie for credit
unions' investment funds. Capital for corporate credit unions is
defined as the sum of a corporate credit union's retained earnings,
paid-in capital (both member and nonmember), and membership capital.
NCUA refers to this paid-in capital and membership capital as corporate
credit union secondary capital; among other things, these two types of
capital are not insured by NCUSIF and are generally longer-term
investments.[Footnote 29] As of December 31, 2003, 18 out of all 31
corporate credit unions had member paid-in capital accounts, 30 out of
31 had membership capital accounts, and none had nonmember paid-in
capital accounts. However, taking into account that (1) corporate
credit unions and natural person credit unions are not comparable given
their member base, and (2) there are far fewer corporate credit unions
compared with the total number of federally insured credit unions,
those 18 corporate credit unions with member paid-in capital and 30
with membership capital do not provide a representative or sufficient
sample that can be used as a model to demonstrate how secondary capital
could be used for all federally insured credit unions. Thus, the
limited experience of corporate credit unions with member paid-in
capital, coupled with the lack of experience with nonmember capital
sources, provides little insight into the potential demand and pricing
of secondary capital instruments for all federally insured credit
unions.
Although the Credit Union Industry Lacks Consensus on Proposals, One
Industry Group Has Developed a Set of Principles:
The credit union industry as a whole has neither endorsed secondary
capital nor put forth a specific secondary capital proposal; however,
several officials with whom we spoke referred to the principles of the
National Association of Federal Credit Unions (NAFCU) board for the
development of a secondary capital instrument as a set of criteria to
consider. Listed in table 2 are the NAFCU board's principles
recommended for any secondary capital instrument designed for use by
all federally insured credit unions.
Table 2: NAFCU Board's Seven Principles for a Viable Alternative
Capital Model:
1. Preserve the not-for-profit, mutual, member-owned and cooperative
structure of credit unions and ensure that ownership interest
(including influence) remains with the members.
2. Ensure that the capital structure of credit unions is not
fundamentally changed and that the safety and soundness of the credit
union community as a whole is preserved.
3. Provide a degree of permanence such that a sudden outflow of capital
will not occur.
4. Allow for a feasible means to augment capital.
5. Provide a solution with market viability.
6. Ensure that any proposed solution applies for PCA purposes (to
include risk-based capital as appropriate) or changes the definition of
net worth to include other equity capital balances.
7. Ensure that any proposed solution qualifies as equity capital
balances under GAAP; and qualifies as an amendment redefining net
worth.
Source: NAFCU.
[End of table]
While we believe that this list incorporates key factors that should be
considered for an alternative capital proposal, it should be noted that
this is not an exhaustive list of all the possible concerns that may
develop as a result of allowing all federally insured credit unions the
use of alternative capital instruments. NAFCU officials told us that
they have not been able to produce an alternative capital proposal that
satisfies these seven principles because of some of the inherent
tensions among the principles. For example, were alternative capital
issued only within the credit union system, the number of investors
would be more limited than if it were issued to the general public,
suggesting that a viable alternative capital instrument should be
issued in the markets--that is, outside of the credit union system.
However, issuing alternative capital instruments outside of the credit
union system may create another "class" of owners, thereby changing the
nature of credit unions.
While Many View Risk-Based Capital as an Enhancement to PCA for Credit
Unions, Key Structural Issues Remain Unresolved:
The debate about the potential use of risk-based capital for all credit
unions revolves around key structural issues, including (1) the extent
to which risk-based ratios would be used to augment, versus replace,
the current PCA net worth (leverage) requirements and (2) how key risk
components and weights that are appropriate to the unique
characteristics of credit unions would be defined. While all banks and
thrifts are required to meet both a risk-based capital ratio and a
leverage ratio to be classified as adequately capitalized, most credit
unions are required to meet only one--a leverage ratio--to be
classified as adequately capitalized. Bank and thrift regulators
recognized the limitations of a solely risk-based capital requirement
and continued the leverage requirements to address other factors that
can affect a bank's financial condition, which a risk-based ratio does
not address. NCUA has adopted a risk-based component of PCA; however,
it affects only a small percentage of credit unions--those that meet
NCUA's definition of "complex." Though a credit union trade association
has put forward two risk-based capital proposals, neither has garnered
industry consensus. Moreover, each proposal lacked details of key
components upon which to base any assessment of their merits. NCUA
officials told us they are developing, but have not yet finalized, a
risk-based capital proposal to augment current PCA for all credit
unions that they believe acknowledges the unique nature of credit
unions and incorporates the relevant and material risks credit unions
face.
Leverage Ratio Requirements Used to Augment Risk-Based Capital for All
Banks and Thrifts:
FDICIA requires all banks and thrifts to meet both a risk-based and a
leverage requirement.[Footnote 30] Leverage ratios have been part of
bank regulatory requirements since the 1980s. They were continued after
the introduction of risk-based capital requirements as a cushion
against risks not explicitly covered in the risk-based capital
requirements. According to regulatory guidelines on capital adequacy,
the final supervisory judgment of a bank's capital adequacy may differ
from the conclusions that might be drawn solely from the risk-based
capital ratio. Banking regulators recognized that the risk-based
capital ratio does not incorporate other factors that can affect a
bank's financial condition, such as interest-rate exposure, liquidity
risks, the quality of loans and investments, and management's overall
ability to monitor and control financial and operating risks.[Footnote
31] FDICIA also requires bank regulators to monitor other risks, such
as interest-rate and concentration risks.[Footnote 32]
FDICIA requires the federal bank and thrift regulators to establish
criteria for classifying depository institutions into five capital
categories: well-capitalized, adequately capitalized,
undercapitalized, significantly undercapitalized, and critically
undercapitalized. Figure 3 illustrates four capital categories and
ratio requirements of FDICIA's PCA provisions.
Figure 3: Summary of FDICIA Capital Categories and Ratio Requirements:
[See PDF for image]
[A] The leverage ratio can be as low as 3 percent if the institution
has a regulator-assigned composite rating of 1. Regulators are to
assign a composite rating of 1 only to institutions considered to be
sound in almost every respect of operations, condition, and
performance.
[B] An institution cannot be considered to be well-capitalized if it is
subject to a formal regulatory enforcement action that requires the
institution to meet and maintain a specific capital level.
[End of figure]
Although not shown in figure 3, a fourth ratio--tangible equity--is
used to categorize an institution as critically
undercapitalized.[Footnote 33] Any institution that has a 2 percent or
less tangible equity ratio is considered critically undercapitalized,
regardless of its other capital ratios. The amount of capital held by a
bank is to be greater than or equal to the leverage ratio. However, if
the risk-based capital calculation yields a higher capital requirement,
the higher amount is the minimum level required.[Footnote 34]
Although U.S. bank risk-based capital guidelines address several types
of risk, only credit and market risk are explicitly
quantified.[Footnote 35] The quantified risk-based capital standard is
defined in terms of a ratio of qualifying capital divided by risk-
weighted assets. All banks are required to calculate their credit risk
for assets, such as loans and securities; and off-balance sheet items,
such as derivatives or letters of credit.[Footnote 36] There are two
qualifying capital components in the risk-based credit risk
computation--core capital (tier 1) and supplementary capital (tier 2).
In addition to credit risk, banks with significant market risk
exposures are required to calculate a risk-based capital ratio that
takes into account market risk in positions such as securities and
derivatives in an institution's trading account and all foreign
exchange and commodity positions, wherever they are located in the
bank.[Footnote 37] The market-risk capital ratio augments the
definitions of qualifying capital in the credit risk requirement by
adding an additional capital component (tier 3). Tier 3 capital is
unsecured, subordinated debt that is fully paid up, has an original
maturity of at least 2 years, and is redeemable before maturity only
with approval by the regulator. To be included in the definition of
tier 3 capital, the subordinated debt must include a lock-in clause
precluding payment of either interest or principal (even at maturity)
if the payment would cause the issuing bank's risk-based capital ratio
to fall or remain below the minimum requirement.
Current Risk-Based Component of PCA for Credit Unions Applies to Few
Credit Unions:
NCUA's PCA risk-based capital rule currently applies to relatively few
credit unions--approximately 8 percent of all federally insured credit
unions that were designated as "complex" as of December 31,
2003.[Footnote 38] It should be noted that none of the five largest
credit unions, and only one of the top 10 credit unions in terms of
assets, met NCUA's definition of complex. CUMAA mandated a risk-based
net worth requirement for "complex" credit unions, for which NCUA was
required to formulate a definition according to the risk level of the
credit union's portfolios of assets and liabilities.[Footnote 39] These
credit unions are subject to an additional risk-based net worth
requirement to compensate for material risks, against which a 6 percent
net worth ratio may not provide adequate protection. Specifically, the
risk-based net worth calculation measures the risk level of on-and off-
balance sheet items in the credit union's "risk portfolios."[Footnote
40]
NCUA uses two methods to determine whether a complex credit union meets
its risk-based net worth requirement: (1) a "standard calculation,"
which uses specific standard component amounts; and (2) a calculation
using alternative component amounts.[Footnote 41] A credit union's
risk-based net worth requirement is the sum of eight standard
components, which include such items as unused member business loan
commitments and allowance for loan and lease losses. Appendix II
provides an example of the standard calculation of the risk-based net
worth requirement, including the definitions of the risk portfolios and
weighted average life for investments. Although not shown in appendix
II, the alternative method of calculating the risk-based requirement
involves weighting four of the risk portfolio components--long-term
real estate loans, member business loans, investments, and loans sold
with recourse--according to their remaining maturity, weighted average
life, and weighted average recourse, respectively.[Footnote 42] In
addition, the risk-based net worth requirement allows credit unions
that succeed in demonstrating mitigation of interest-rate or credit
risk to apply to NCUA for a risk mitigation credit. The credit, if
approved, would reduce the risk-based net worth requirement a credit
union must satisfy to remain classified as adequately capitalized or
above. According to NCUA, between March 2002 and December 2003 there
have been 38 credit unions that failed the standard risk-based net
worth requirement, with two credit unions failing both the standard and
alternative calculation requirements.[Footnote 43] In addition, toward
the end of 2003 two credit unions submitted applications for a risk
mitigation credit.
Existing Industry Proposals Lack Specificity and Consensus:
The credit union officials with whom we spoke disagreed whether the
current PCA system should be replaced or augmented by a risk-based PCA
system. One credit union official--a recognized proponent of secondary
capital--told us that risk-based capital should be used to augment, but
not replace, the current leverage-based net worth capital requirements.
Conversely, two industry groups told us that they see risk-based
capital requirements serving as a complement to secondary capital, if
it were allowed to be included as a component of net worth. Many credit
union officials told us that current PCA is "one size fits all" but
would not comment further on risk-based capital. In addition, NASCUS
told us that it has recently endorsed the risk-based language in a
House of Representatives bill, although it continues to support
secondary capital for all credit unions.[Footnote 44] However, it
should be noted that for most credit unions, risk-based assets are less
than total assets; therefore, a given amount of capital would have a
higher net worth ratio if risk-based assets were used. And capital
requirements would likely be reduced if risk-based capital were an
alternative, rather than a complement, to leverage ratios.
CUNA put forward two risk-based capital proposals that they believe (1)
would preserve the requirement that regulators must take prompt and
forceful supervisory actions against credit unions that become
seriously undercapitalized and (2) would not encourage well-capitalized
credit unions to establish such large buffers over minimum net worth
requirements that they would become overcapitalized. However, both
proposals lacked details of key components that would be needed in
order to assess their merits. The first CUNA proposal does not provide
a clear definition of risk assets. The second CUNA proposal does not
provide specific risk weights and asset classifications appropriate for
credit unions.
The first proposal would replace the current two-phased PCA system with
a single system using risk-based and net worth ratio requirements for
all credit unions.[Footnote 45] This system would incorporate NCUA's
pre-CUMAA definition of risk assets--all loans not guaranteed by the
federal government, and all investments with maturities over 5 years--
into the PCA system by modifying the current definition of net worth
ratio.[Footnote 46] Specifically, the first proposal would lower the
current net worth ratios for each PCA category to parallel the leverage
ratio requirement for banks and thrifts and add a risk-based net worth
ratio requirement using the existing PCA threshold levels for credit
unions. For example, an adequately capitalized credit union would be
defined as having a risk-based net worth ratio of 6 percent or greater
and a net worth ratio of 4 percent or greater. Under this proposal, if
a credit union's net worth ratio falls into different categories by
risk and total assets, the lower classification would apply. The
proposal stated that risk assets could be defined as nonguaranteed
loans and long-term investments, or NCUA could be instructed to define
risk assets in a manner consistent with its pre-CUMAA requirements.
The second proposal would incorporate components of both the Basel
capital framework currently in use by banks and thrifts in the United
States and the risk-based portion of the current credit union PCA
applicable to complex credit unions. Specifically, this proposal states
that net worth requirements could be based on risk weights for assets
as in place for banks, but with the weights established on the basis of
both credit and interest-rate risk. Under this proposal, the risk
weights could be set by NCUA based on the Basel system.[Footnote 47]
According to the second proposal, it is likely that NCUA could choose
to adopt some credit-risk weights that are different from those
currently in use by bank and thrift regulators under the Basel system
because some of the weights would be assigned on the basis of interest-
rate risk. The proposed risk-based ratio requirements for each PCA
category would parallel the current total risk-based requirement for
banks and thrifts. In addition, this proposal states that a credit
union could also be required to maintain a net worth ratio equivalent
to the leverage ratio required for banks and thrifts. Similar to the
first proposal, if a credit union's net worth ratio falls into
different categories by risk and total assets, the lower classification
would apply. For example, in order to be adequately capitalized under
the second proposal, a credit union would have to have a risk-based
ratio of 8 percent or greater and a net worth ratio of 4 percent or
greater.
NCUA Suggests Using Risk-Based Capital Requirements for All Credit
Unions:
According to NCUA officials, NCUA envisions a risk-based PCA system
similar in structure to that currently employed in the banking system.
However, they stated that NCUA would tailor the risk weights and the
categories into which assets fall, to take into consideration the
unique nature of credit unions and the loss histories of their asset
portfolios. In addition, the NCUA officials told us that a risk-based
credit union PCA system should be designed to address all relevant and
material risks (for example, interest-rate risk). According to these
NCUA officials, the credit union PCA system should be robust enough so
as not to be "one-size-fits-all," but simple enough to facilitate
administration of the system and be well understood by credit unions.
NCUA officials told us that they are in the process of developing a
risk-based PCA proposal that would be used for all credit unions, not
just complex credit unions. See appendix III for items being used in
the development of NCUA's risk-based PCA proposal.
NCUA officials emphasized that the CUMAA mandate to take prompt
corrective action to resolve problems at the least long-term cost to
NCUSIF is good public policy and consistent with NCUA's fiduciary
responsibility to the share insurance fund. However, they stated that
they believe additional flexibility is needed to enable NCUA to work
with problem institutions. They explained that the additional
flexibility could be structured to constrain any tendency toward
regulatory forbearance and preserve the objective of PCA. NCUA
officials told us that they believe a revised system would alleviate
most concerns that credit unions have with PCA. They believe changing
the system would provide credit union management with the ability to
manage compliance by making adjustments to their asset portfolios,
maintain ample protection for the system and individual credit unions,
and preserve NCUA's ability to address net worth problems. NCUA
officials told us that such a system would likely obviate the need or
desire for secondary capital for the vast majority of credit unions.
Observations:
Despite concerns raised by some in the credit union industry, available
information indicates no compelling need for using secondary capital
instruments to bolster the net worth of credit unions, or to make other
significant changes to PCA as it has been implemented for credit
unions. Available indicators suggest that the credit union industry as
a whole has not been overly constrained as a result of the
implementation of PCA. Notably, credit unions were able to maintain
capital levels well in excess of the PCA requirements during a period
of rapid share or deposit growth. One of the inherent weaknesses in PCA
is its focus on capital, which typically is a lagging indicator of a
financial institution's health. As such, it will be important for NCUA
to distinguish between capital deterioration that occurs because of
fundamental weaknesses in the institution's structure or management
versus temporary capital shortfalls due to constraints beyond a credit
union's control. While we do not find the arguments for using secondary
capital instruments to be compelling, to the extent that well-managed
and -operated credit unions do experience temporary capital
constraints, NCUA may want to revisit the concept of an abbreviated net
worth restoration plan for marginally undercapitalized credit unions.
Consideration of changes such as this seem to be more consistent with
the notion that the problems some credit unions may be facing are
temporary and, therefore, best tackled with temporary, not more
permanent, solutions, such as secondary capital instruments.
Allowing credit unions to use secondary capital instruments to meet
their regulatory net worth requirements would raise a number of issues
and concerns. One of the key issues is who would be allowed to invest
in the secondary capital instruments of credit unions. While allowing
credit unions to sell secondary capital instruments to investors
outside of the credit union industry would provide market discipline,
this would raise concerns about the potential impact on the member-
owned, cooperative nature of credit unions. Some have proposed limiting
potential investors to credit union members, other credit unions, and
corporate credit unions; however, in-system investors could impose less
discipline and raise systemic risk concerns if it were to create a
situation where weaker credit unions brought down stronger credit
unions due to secondary capital investments. Other issues relate to the
specific form of the capital instruments, and how they would be
incorporated into the regulatory net worth requirement for credit
unions. The credit union industry itself appeared divided on the
desirability or appropriate structure of secondary capital instruments.
Conceptually, the potential use of a risk-based capital system for all
credit unions appears less controversial. Risk-based capital is
intended to require institutions with riskier profiles to hold more
capital than institutions with less risky profiles. However, not all of
the risks that credit unions face, such as liquidity and operational
risk, can be quantified. In recognition of the limitations of risk-
based capital systems, the bank and thrift regulators use both risk-
based and nonrisk weighted (leverage ratio) capital requirements for
PCA purposes. The requirements are used in tandem to better ensure
safety and soundness in banks and thrifts. Among the numerous issues
that would need to be addressed in a risk-based capital proposal, given
the unique nature of credit unions, would be the appropriate risk
weights and categories into which assets fall and the appropriate risk-
based and nonrisk-based capital ratios for each PCA category. We are
aware that NCUA is constructing a more detailed risk-based capital
proposal that includes both risk-based and leverage requirements for
all credit unions and believe that any proposal should be based on the
premise that risk-based capital be used to augment, but not replace,
the current net worth requirement for credit unions.
We remain a strong supporter of PCA as a regulatory tool. The system of
PCA implemented for credit unions is comparable with the PCA system
that bank and thrift regulators have used for over a decade. The
concerns raised by the credit union industry appear to reflect the
inherent tension between credit union managers' desire to maintain the
optimal amount of capital to efficiently fuel growth and returns to
credit union members and Congress's desire to protect the federal share
insurance funds from losses that could have been prevented by early and
forceful supervisory action. As we stated in our October 2003 report,
credit unions have been subject to PCA for a short time, and the
advantages and disadvantages of the current program are not yet
evident. Additional time and greater experience with the use of PCA in
the credit union industry would provide greater insight into the need
for any significant changes to PCA as well as the best options for any
changes.
Agency Comments and Our Evaluation:
We provided a draft of this report to the Chairman of the National
Credit Union Administration and the Secretary of the Treasury for
review and comment. We received written comments from NCUA that are
reprinted in appendix IV. In addition, we received technical comments
from NCUA and Treasury that we incorporated into this report, as
appropriate.
NCUA concurred with this report's assessment that there is no
compelling need for secondary capital. For example, NCUA concurred that
there are key unresolved issues, such as whether secondary capital
instruments would be commercially viable, to whom these instruments
could and should be sold (e.g. inside versus outside investors), the
effects on the member-owned, cooperative structure of credit unions,
and any safety and soundness and systemic risk implications posed by
this activity. NCUA also concurred that there is a lack of consensus
within the credit union system on the need for and appropriate
structure of secondary capital instruments. Finally, NCUA stated that
the vast majority of insured credit unions maintain extremely strong
capital positions, notwithstanding a recent prolonged period of rapid
share growth.
NCUA stated that it concurred with views expressed by many within the
credit union industry that the current PCA tripwires were too high.
NCUA disagreed with Treasury's rationale for the higher limit--1
percent for the deposit in NCUSIF and another 1 percent for the typical
credit union's capital invested in corporate credit unions--than that
imposed on banks and thrifts. NCUA stated that under GAAP, which
Congress mandated credit unions follow, the NCUSIF deposit is
considered an asset on the financial statements of a credit union.
Further, NCUA stated that the NCUSIF deposit is not related to a credit
union's net worth from either an accounting or financial risk
standpoint. In addition, NCUA noted that not all credit unions belong
to corporate credit unions or hold this form of investment; therefore,
using a "one size fits all" approach to trigger PCA supervisory actions
based on this assumption is inherently unfair. Finally, NCUA stated
that PCA tripwires are too high, penalizes institutions with
conservative risk profiles, and allows higher risk earnings strategies
without commensurate net worth levels. While we did not perform an
evaluation of PCA, which would include a discussion of the thresholds,
we note that the NCUSIF deposit is not liquid and, therefore, not
immediately accessible for credit unions to use as a capital buffer.
Though we agree that not all credit unions are engaged in corporate
credit union investments, we believe that these investments are still
relevant as a PCA consideration and any risk-based capital standards
should appropriately recognize these investments.
NCUA stated that based on their experience gained to date with the PCA
system for federally insured credit unions, adjustments are needed to
better achieve PCA's overall objectives. Specifically, NCUA stated that
the adjustments should move PCA to a more fully risk-based system, with
a lower leverage ratio required of a credit union to meet the well-
capitalized levels. NCUA believes that a well-capitalized leverage
requirement in the range of 5 percent would be more than sufficient to
meet the safety and soundness goals of PCA. However, NCUA did not
provide evidence that the current 7 percent net worth requirement has
been a hardship to the credit union industry. As noted in this report,
credit unions cannot quickly raise their capital through the issuance
of capital stock when a financial need arises, they must rely on
retained earnings to build sufficient capital--which necessarily takes
time. Further, we believe that the generally favorable economic climate
for credit unions coupled with the relatively short amount of time that
PCA has been in place for credit unions do not provide a sufficient
testing of the current system of PCA for credit unions to determine if
changes are warranted.
NCUA stated that it recognized that, as our draft report indicated, the
efficacy of a risk-based system is highly dependent on the details of
the risk categories and weights, as well as the complementary
relationship between the risk-based and leverage requirements. However,
NCUA stated that the draft report suggested that a risk-based system
would result in risk assets being lower than total assets for most
credit unions, resulting in a given amount of capital producing a
higher net worth ratio. NCUA stated that such a result was not a
foregone conclusion. NCUA indicated that a proposal under consideration
included risk categories with weights at and above 100 percent. The
statement in the draft report was based on our discussion with
representatives of the credit union industry. As we noted in our draft
report, no detailed proposals regarding a risk-based system for all
credit unions was available for our analysis, including that being
developed by NCUA. In the absence of details, we cannot comment on the
ultimate effect of a proposal that is in the process of being developed
on the required capital levels for credit unions. However, we believe
that, used in tandem with leverage capital requirements, any risk-based
capital standards should appropriately recognize the risks credit
unions face.
In response to the statement in our draft report that PCA was intended
to act as a restraint on growth, NCUA stated that it was important to
differentiate overly aggressive growth from robust growth, consistent
with sound business strategy, experienced by healthy credit unions.
While we agree that there are different types of growth, institutions
still need to hold sufficient capital regardless of the type of growth
experienced. As noted in this report, PCA was intended to curb
aggressive growth, since uncontrolled growth was one of the common
attributes of banks and thrifts that failed during the banking crisis
of the late 1980s and early 1990s. Moreover, our analysis of aggregated
credit union data indicated that credit unions have been able to
maintain a rate of growth that has exceeded that of banks and thrifts
in the three full calendar years that PCA has been in place for credit
unions.
NCUA noted that our draft report suggested that NCUA revisit the
concept of an abbreviated NWRP for marginally undercapitalized credit
unions for situations involving temporary capital shortfalls. It noted
that the statutory language of CUMAA precluded NCUA from providing any
significant regulatory relief in this regard. NCUA stated that it
supported a statutory change to provide NCUA the regulatory authority
to waive the requirement to submit a NWRP for credit unions that have a
temporary, marginal drop in their net worth ratio below adequately
capitalized, as determined on a case-by-case basis. While NCUA put
forth a proposed rule on an abbreviated NWRP, NCUA did not pursue it
further. We believe it is important that NCUA explore and use all of
the available options and discretion provided by CUMAA. While an
abbreviated NWRP may not be viewed by NCUA or the industry as granting
significant regulatory relief, the experiences gained with an
abbreviated NWRP would provide NCUA and Congress with additional
information regarding the need for additional regulatory authorities.
Moreover, it is important to note that none of the federal bank or
thrift regulators have similar authority to that being sought by NCUA.
As agreed with your offices, unless you publicly announce the contents
of this report earlier, we plan no further distribution until 30 days
from its issuance date. At that time, we will send copies of this
report to the Chairman and Ranking Minority Member of the Senate
Committee on Banking, Housing, and Urban Affairs. We also will send
copies to the National Credit Union Administration and the Department
of the Treasury and make copies available to others upon request. In
addition, this report will be available at no charge on the GAO Web
site at [Hyperlink, http://www.gao.gov].
This report was prepared under the direction of Harry Medina, Assistant
Director. If you or your staffs have any further questions, please
contact me at (202) 512-8678 or [Hyperlink, hillmanr@gao.gov], or
Harry Medina, Assistant Director, at (415) 904-2220 or [Hyperlink,
medinah@gao.gov]. Key contributors are acknowledged in appendix V.
Signed by:
Richard J. Hillman:
Director, Financial Markets and Community Investment:
[End of section]
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
To identify and describe concerns regarding the current capital
requirements for credit unions, we interviewed credit union industry
groups, several credit union chief executive officers, credit union
regulators, and two banking regulators. Additionally, through these
interviews we gathered information on the issues and concerns
associated with the potential use of secondary capital and risk-based
capital by credit unions, including any documented proposals. We also
conducted a literature search to identify studies on the potential use
of secondary capital by credit unions and spoke with academics and
other industry observers.
To illustrate credit union prompt corrective action (PCA) capital
levels over time, we conducted research on PCA regulations and reviewed
the National Credit Union Administration's (NCUA) Form 5300 (call
report) database for 1994-2003 for federally insured, natural person
credit unions. We reviewed NCUA-established procedures for verifying
the accuracy of the Form 5300 database and found that the data
constituting this database are verified on an annual basis, either
during each credit union's examination, or through off-site
supervision. We determined that the data were sufficiently reliable for
the purposes of this report. In addition, we reviewed capital
requirements of banks and thrifts for comparison with credit union
capital requirements.
Credit unions have been subject to PCA programs for a short time, and
the advantages and disadvantages of the current programs are not yet
evident. As a result, we did not perform an evaluation or assessment of
credit union PCA. We are aware that NCUA is constructing a more
detailed risk-based capital proposal that incorporates both risk-based
and leverage requirements; however, due to the lack of formalized
details, we could not perform a meaningful assessment of the proposal.
Given that none of the secondary capital or risk-based PCA proposals
provided to us have garnered credit union industry consensus or contain
sufficient details on which to base an assessment, we did not perform
an evaluation of these proposals or an analysis of their potential
benefits and implications.
We conducted our work in Washington, D.C., from November 2003 through
July 2004 in accordance with generally accepted government auditing
standards.
[End of section]
Appendix II: Definitions of Risk Portfolios and Weighted-Average Life
of an Investment, and a Risk-Based Standard Calculation Example:
Table 3: Risk Portfolios Defined:
Risk portfolio: Long-term real estate loans;
Assets, liabilities or contingent liabilities: Total real estate loans
and real estate lines of credit (excluding member business loans) with
a maturity (and next rate adjustment period if variable rate) greater
than 5 years.
Risk portfolio: Member business loans outstanding;
Assets, liabilities or contingent liabilities: Member business loans
outstanding.
Risk portfolio: Investments;
Assets, liabilities or contingent liabilities: As defined by federal
regulation or applicable state law.
Risk portfolio: Low-risk assets;
Assets, liabilities or contingent liabilities: Cash on hand and
National Credit Union Share Insurance Fund (NCUSIF) deposit.
Risk portfolio: Average-risk assets;
Assets, liabilities or contingent liabilities: 100 percent of total
assets minus sum of risk portfolios above.
Risk portfolio: Loans sold with recourse;
Assets, liabilities or contingent liabilities: Outstanding balance of
loans sold or swapped with recourse, except for loans sold to the
secondary mortgage market with a recourse period of 1 year or less.
Risk portfolio: Unused member business loan commitments;
Assets, liabilities or contingent liabilities: Unused commitments for
member business loans.
Risk portfolio: Allowance for loan and lease losses;
Assets, liabilities or contingent liabilities: Allowance for loan and
lease losses limited to equivalent of 1.50 percent of total loans.
Source: NCUA Rules and Regulations, 12 C.F.R. §702.104.
[End of table]
Table 4: Weighted-Average Life of Investments:
Investment: Registered investment companies and collective investment
funds;
Weighted-average life: i. Registered investment companies and
collective investment funds: As disclosed in prospectus or trust
instrument, but if not disclosed, greater than 5 years, but less than
or equal to 7 years;
ii. Money market funds and short-term investment funds: 1 year or less.
Investment: Callable fixed-rate debt obligations and deposits;
Weighted-average life: Period remaining to maturity date.
Investment: Variable-rate debt obligations and deposits;
Weighted- average life: Period remaining to next adjustment date.
Investment: Capital in mixed-ownership government corporations and
corporate credit unions;
Weighted-average life: Greater than 1 year, but less than or equal to
3 years.
Investment: Investments in credit union service organizations;
Weighted-average life: Greater than 1 year, but less than or equal to
3 years.
Investment: Other equity securities;
Weighted-average life: Greater than 10 years.
Source: NCUA Rules and Regulations, 12 C.F.R. §702.105.
[End of table]
Table 5: Example of the Standard Calculation of the Risk-Based Net
Worth Requirement:
Risk portfolio: Quarter-end total assets;
Dollar balance: $200,000,000;
Amount as a percentage of quarter-end total assets (percent): 100%.
Risk portfolio: Long-term real estate loans;
Dollar balance: $60,000,000;
Amount as a percentage of quarter-end total assets (percent): 30% = ;
Standard component (percent): 2.20%;
Risk portfolio: Long-term real estate loans; Threshold amount: 0 to 25
percent;
Amount as a percentage of quarter-end total assets (percent): 25%;
Risk weighting: 0.06;
Amount times risk weighting (percent): 1.5%;
Risk portfolio: Long-term real estate loans; Excess amount: over 25
percent;
Amount as a percentage of quarter-end total assets (percent): 5%;
Risk weighting: 0.14;
Amount times risk weighting (percent): 0.7%;
Risk portfolio: Member business loans outstanding;
Dollar balance: $35,000,000;
Amount as a percentage of quarter-end total assets (percent): 17.5% =;
Standard component (percent): 1.10%.
Risk portfolio: Member business loans outstanding; Threshold amount: 0
to 15 percent;
Amount as a percentage of quarter-end total assets (percent): 15%;
Risk weighting: 0.06;
Amount times risk weighting (percent): 0.9%;
Risk portfolio: Member business loans outstanding; Intermediate tier:
> 15 to 25 percent;
Amount as a percentage of quarter-end total assets (percent): 2.5%;
Risk weighting: 0.08;
Amount times risk weighting (percent): 0.2%;
Risk portfolio: Member business loans outstanding; Excess amount: over
25 percent;
Amount as a percentage of quarter-end total assets (percent): 0%;
Risk weighting: 0.14;
Amount times risk weighting (percent): 0%;
Risk portfolio: Investments;
Dollar balance: $50,000,000 =;
Amount as a percentage of quarter-end total assets (percent): 25% =;
Standard component (percent): 1.51%.
Risk portfolio: Investments; Weighted-average life: 0 to 1 year;
Dollar balance: $24,000,000;
Amount as a percentage of quarter-end total assets (percent): 12%;
Risk weighting: 0.03;
Amount times risk weighting (percent): 0.36%;
Risk portfolio: Investments; Weighted-average life: > 1 year to 3
years;
Dollar balance: $15,000,000;
Amount as a percentage of quarter-end total assets (percent): 7.5%;
Risk weighting: 0.06;
Amount times risk weighting (percent): 0.45%;
Risk portfolio: Investments; Weighted-average life: >3 years to 10
years;
Dollar balance: $10,000,000;
Amount as a percentage of quarter-end total assets (percent): 5%;
Risk weighting: 0.12;
Amount times risk weighting (percent): 0.6%;
Risk portfolio: Investments; Weighted-average life: > 10 years;
Dollar balance: $1,000,000;
Amount as a percentage of quarter-end total assets (percent): 0.5%;
Risk weighting: 0.20;
Amount times risk weighting (percent): 0.1%;
Risk portfolio: Low-risk assets;
Dollar balance: $4,000,000;
Amount as a percentage of quarter-end total assets (percent): 2%;
Risk weighting: 0.00;
Standard component (percent): 0%.
Risk portfolio: Sum of risk portfolios above;
Dollar balance: $149,000,000;
Amount as a percentage of quarter-end total assets (percent): 74.5%.
Risk portfolio: Average-risk assets;
Dollar balance: $51,000,000;
Amount as a percentage of quarter-end total assets (percent): 25.5%;
Risk weighting: 0.06;
Standard component (percent): 1.53%.
Risk portfolio: Loans sold with recourse;
Dollar balance: $40,000,000;
Amount as a percentage of quarter-end total assets (percent): 20%;
Risk weighting: 0.06;
Standard component (percent): 1.20%.
Risk portfolio: Unused member business loan commitments;
Dollar balance: $5,000,000;
Amount as a percentage of quarter-end total assets (percent): 2.5%;
Risk weighting: 0.06;
Standard component (percent): 0.15%.
Risk portfolio: Allowance for loan and lease losses;
Dollar balance: $2,040,000;
Amount as a percentage of quarter-end total assets (percent): 1.02%;
Risk weighting: (1.00);
Standard component (percent): (1.02)%.
Risk portfolio: Sum of standard components:
Standard component (percent): 6.67%.
Source: NCUA Rules and Regulations, 12 C.F.R. §702, App. A.
[End of table]
[End of section]
Appendix III: Items in Use by NCUA in Developing Its Risk-Based Capital
Proposal:
While NCUA has not finalized its risk-based PCA proposal for all credit
unions, NCUA officials provided us items being used in the development
of their risk-based PCA proposal: [Footnote 48]
* NCUA supports a statutorily mandated PCA system, with a minimum core
leverage requirement (hard floor of 2 percent of total assets for
critically undercapitalized); a statutory definition of net worth (with
ability through regulation to reduce what qualifies as net worth, not
increase it); and statutory thresholds based on risk assets defined by
NCUA for the various net worth categories. NCUA also believes it should
be provided with the authority to set the remaining elements of the
risk-based PCA system by regulation.
* With the exception of being able to set by regulation a minimum level
of net worth in relation to total assets (for example, 4 percent or 5
percent, tied to the credit union's CAMEL rating) to be considered
adequately capitalized, NCUA believes the current thresholds (but in
relation to risk assets) are acceptable and best left established by
statute.[Footnote 49] However, NCUA wants to keep the parity provision
in the current statute, which provides the authority to change the
thresholds by regulation, commensurate with any changes to the banks'
PCA thresholds.[Footnote 50]
* With regard to the net worth ratio numerator, NCUA also supports a
statutory definition for net worth, but the current definition should
be expanded beyond retained earnings under generally accepted
accounting principles (GAAP). NCUA believes a better definition of net
worth is equity of the credit union as determined under GAAP and as
authorized by the NCUA board. NCUA believes this would provide the NCUA
board with the authority through regulation to subtract from net worth
balance sheet items (such as goodwill that have no value in the event
of a payout) the NCUA board deems appropriate. Additionally, NCUA
believes that this definition preserves the requirement to comply with
GAAP and limits statutorily what can be included in net worth, while
providing NCUA with the flexibility to reduce assets that count toward
net worth for PCA purposes but that do not have value to the insurance
fund.
* With regard to the net worth ratio denominator, NCUA advocates having
the regulatory flexibility to set the risk weights for assets and
adjust them, as it deems appropriate.
* In cases where there is a marginal drop in net worth below adequately
capitalized, NCUA advocates having the regulatory flexibility to
temporarily waive a credit union's requirement to submit a net worth
restoration plan if: (a) the credit union is CAMEL-rated 1 or 2 with a
net worth ratio in the range of 5 percent to 7 percent, (b) the credit
union's book of business does not present a safety and soundness issue,
and (c) the credit union's assets are well managed. In addition, NCUA
desires the regulatory flexibility to revisit the credit union after a
specified time to determine if the temporary waiver is still
appropriate and, if not, require the credit union to submit a net worth
restoration plan. NCUA believes that this would reduce the burden
placed on credit unions experiencing a small, temporary decline in the
net worth ratio due to circumstances such as unsolicited, robust share
growth that do not pose a safety and soundness concern. Further, NCUA
believes such a provision would still provide NCUA with adequate
authority to address any concerns on a case-by-case basis.
[End of section]
Appendix IV: Comments from the National Credit Union Administration:
National Credit Union Administration:
Office of the Chairman:
July 9, 2004:
Richard J. Hillman, Director:
Financial Markets and Community Investment:
United States General Accounting Office:
Washington, D.C.
Re: Draft GAO Report 04-849:
Dear Mr. Hillman:
Thank you for the opportunity to review and comment on the General
Accounting Office's (GAO) draft report entitled Credit Unions -
Available Information Indicates No Compelling Need for Secondary
Capital (the report). On behalf of the National Credit Union
Administration (NCUA), I would like to express our appreciation for the
professionalism exhibited by your staff and your careful consideration
of this important matter.
As the report discusses, questions surrounding the appropriateness of
authorizing all federally insured credit unions to use secondary
capital to meet prompt corrective action (PCA) requirements are
numerous and complex. We agree with your conclusion that there are key
unresolved issues, such as whether or not secondary capital instruments
would be commercially viable, to whom these instruments could and
should be sold (e.g., inside versus outside investors), the effects on
the member-owned cooperative structure of credit unions, and any safety
and soundness and systemic risk implications posed by this activity. We
also agree that there is a lack of consensus within the credit union
system on the need for and appropriate structure of secondary capital
instruments. In view of these considerations and the fact that the vast
majority of insured credit unions maintain extremely strong capital
positions notwithstanding a recent prolonged period of rapid share
growth, at this time we accept your conclusion that a case for
secondary capital has not been made. We fully expect that there will be
continued debate and study of this issue within the credit union
system.
The report does, however, discuss what we believe are valid concerns
with the PCA system established by the Credit Union Membership Access
Act (CUMAA). NCUA strongly believes the statutory mandate to take
prompt corrective action to resolve problems at the least long-term
cost to the National Credit Union Share Insurance Fund (NCUSIF) is
sound public policy consistent with NCUA's fiduciary responsibility to
the NCUSIF. However, now that we have gained experience with a PCA
structure for federally insured credit unions we believe there is a
need to make adjustments to better achieve its overall objectives.
These adjustments should move PCA to a more fully risk-based system,
with a lower leverage ratio (ratio of net worth to total assets)
required of a credit union to meet the "well-capitalized" level. In
view of the conservative nature of credit unions (driven by their
cooperative, member-owned structure), the comparatively low loss
history of the credit union system, and the fact that our experience
indicates that the great majority of credit unions manage their net
worth to a level higher than the leverage requirement, we believe a
"well-capitalized" leverage requirement in the range of 5% would be
more than sufficient to meet the safety and soundness goals of PCA.
Some additional details of the risk-based system that we envision are
discussed below.
The report notes that PCA is intended to act as a restraint on growth
that outpaces a credit union's ability to generate commensurate
earnings, especially aggressive growth strategies that have a high
correlation to problems in financial institutions. However, it is
important to differentiate overly aggressive growth from robust growth,
consistent with sound business strategy, experienced by healthy credit
unions.
When a credit union experiences safe but strong growth that in the
short term exceeds the ability of a prudent earnings strategy to fund
net worth at the same pace, NCUA believes the key factor is how the
credit union invests these funds. Page 17 of the report states "credit
union managers are expected to manage the growth of their institutions
so that an influx of member deposits would not cause the credit union
to become subject to PCA." However, the current "one-size-fits-all" PCA
system does not permit this, short of turning away deposits after
dividend rates have been reduced to below market rates. Under a risk-
based system with a lower leverage requirement, credit unions would
have greater ability to manage compliance by shifting investment
strategies from longer-term, higher credit risk assets to shorter-term,
lower credit risk assets resulting in the need to hold less capital on
these safer assets with lower risk weights. This would provide credit
unions with the ability to manage compliance with PCA by also managing
the asset side of the balance sheet.
NCUA also believes that having the ability to waive the requirement for
a net worth restoration plan (NWRP) under certain circumstances would
help address the growth issue. The report suggests NCUA revisit the
concept of an abbreviated NWRP for marginally undercapitalized credit
unions for situations involving temporary capital shortfalls. We
considered this initial proposal carefully. However, the statutory
language of CUMAA precludes NCUA from providing any significant relief
to credit unions in this regard. Thus, we support a statutory change to
provide NCUA the regulatory authority to waive the requirement to
submit a NWRP for credit unions that have a temporary, marginal drop in
their net worth ratio below "adequately capitalized", as determined on
a case-by-case basis.
NCUA concurs with the views expressed by many within the credit union
industry that the PCA tripwires are too high. The current system's high
leverage requirement, coupled with the underlying psychological factors
driving credit union officials to have a cushion above the PCA
requirements, creates a "one-size-fits-all" PCA system. This has the
effect of penalizing institutions with conservative risk profiles. At
the same time, it allows higher risk earnings
strategies without commensurate net worth levels. A well designed risk-
based system with lower leverage requirements would more closely relate
required capital levels with the risk profile of the institution and
allow for better utilization of capital.
The report repeats the Department of Treasury's contention that
Congress determined that a 2% higher limit than that imposed on banks
and thrifts was necessary due to the 1 % deposit in the NCUSIF and
another 1 % of the typical credit union's capital invested in corporate
credit unions. NCUA respectfully disagrees with this rationale.
Under GAAP, which Congress mandated credit unions follow, the NCUSIF
deposit is considered an asset on the financial statements of a credit
union. Further supporting its treatment as a credit union asset, it has
been NCUA's long standing practice to return this deposit when a credit
union exits federally insured status or converts to another form of
financial institution. These funds are also available to absorb losses
in the event of a liquidation or purchase and assumption of a failed
credit union. The NCUSIF deposit is not related to a credit union's net
worth from either an accounting or financial risk standpoint. It would
take a highly improbable massive systemic event to trigger a write-off
of the NCUSIF deposit and recapitalization of the insurance fund.
Further, if the NCUSIF equity ratio declines below 1.2%, CUMAA mandates
that NCUA charge an insurance premium to restore the fund to at least
1.2%.
Regarding natural person credit unions' investment in capital
instruments of corporate credit unions, the report acknowledges that
this was factored into the higher limit because the typical credit
union holds this form of investment. We note that not all credit unions
belong to corporate credit unions or hold this form of investment.
Therefore, using a "one-size-fits-all" approach to trigger PCA
supervisory actions based on this assumption is inherently unfair. We
believe natural person credit unions' investments in capital
instruments of corporate credit unions is best addressed by factoring
any individual institution's at-risk investments in corporate credit
unions into a risk-based PCA system.
We recognize, as the report indicates, the efficacy of a risk-based
system is highly dependent on the details of the risk categories and
weights, as well as the complementary relationship between the risk-
based and leverage requirements. The report suggests a risk-based
system will result in risk assets being lower than total assets for
most credit unions, resulting in a given amount of capital producing a
higher net worth ratio. In fact, a proposal under consideration
includes risk categories with weights at and above 100%. Thus, it is
not a foregone conclusion that the risk-based portion of the PCA system
would result in significantly lower required capital levels.
We agree with the report's assertion that not all risks that credit
unions face can be quantified. Thus, although we are still working on
the details, we envision a risk-based capital structure that works in
tandem with a leverage component. This can be illustrated as follows:
Figure 1: Example of Possible Parameters for a Risk-Based Capital
Requirement in Tandem with a Leverage Requirement for Credit Unions:
[See PDF for image]
[End of table]
We appreciate the inability of GAO and others to comment further on
NCUA's proposal for a more risk-based PCA system until it is fully
developed. We look forward to the continued dialogue on this issue with
all parties sharing our common interest in the continued safety and
soundness of the credit union system. Thank you again for the
opportunity to comment on the draft report. If you have any questions
or need further information, please feel free to contact NCUA Executive
Director J. Leonard Skiles at (703) 518-6321.
Sincerely,
Signed by:
JoAnn M. Johnson:
Chairman:
[End of section]
Appendix V: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Richard J. Hillman, (202) 512-8678 Harry Medina, (415) 904-2220:
Acknowledgments:
In addition to those named above, Heather T. Dignan, Landis L. Lindsey,
Kimberly A. Mcgatlin, Carl M. Ramirez, Barbara M. Roesmann, Paul G.
Thompson, John H. Treanor, and Richard J. Vagnoni made key
contributions to this report.
(250168):
FOOTNOTES
[1] In this report, we use "credit union" to refer to federally
insured, natural person credit unions--those institutions with a
membership consisting of individuals. As of December 2003, there were
9,369 federally insured, natural person credit unions. In contrast,
corporate credit unions have a membership consisting of other credit
unions. As of December 2003, there were 31 corporate credit unions.
[2] Like banks, federally insured credit unions can be federally
chartered or state chartered. NCUA has oversight authority for
federally chartered credit unions and requires its credit unions to
obtain federal share (deposit) insurance, through the National Credit
Union Share Insurance Fund (NCUSIF), which it administers.
Additionally, most state-chartered credit unions also have federal
insurance. Approximately 98 percent of credit unions are federally
insured.
[3] See Pub. L. No. 105-219 §301 (1998), as amended, 12 U.S.C. §1790d
(2000 & Supp. 2004). These actions are set forth in NCUA's regulations
12 C.F.R. Part 702, Subpart B (2004).
[4] Subordinated debt is debt that is either unsecured or has a lower
priority than that of another debt claim on the same asset.
Subordinated debt instruments are not backed or guaranteed by the
federal deposit or share insurance funds.
[5] The document referred to as the Basel Accord is entitled
"International Convergence of Capital Measurement and Capital
Standards, Basel Committee on Banking Supervision" (Basel, Switzerland:
July 1988).
[6] U.S. General Accounting Office, Bank Supervision: Prompt and
Forceful Regulatory Actions Needed, GAO/GGD-91-69 (Washington, D.C.:
Apr. 15, 1991).
[7] Pub. L. No. 102-242 §131(a), 12 U.S.C. §1831o, as amended.
[8] Pub. L. No. 105-219, Title III (1998), codified at 12 U.S.C. §1790d
(2000 & 2003 Supp.). The NCUA's initial implementing regulations were
published at 65 Fed. Reg. 8560 (Feb. 18, 2000).
[9] 12 U.S.C. §1790d(o)(3).
[10] Retained earnings consists of undivided earnings, regular
reserves, and any other appropriations designated by management or
regulatory authorities. This means that only undivided earnings and
appropriations of undivided earnings are included in net worth. As
discussed elsewhere in this report, CUMAA defines "net worth" for low
income credit unions to include uninsured, subordinate capital
accounts. 12 U.S.C. §1790d(o)(2)(B).
[11] 12 C.F.R. §702.2(k)(1) (2004). Call reports are submitted by
credit unions to NCUA and contain data on a credit union's financial
condition and other operating statistics.
[12] 12 C.F.R. §702.2(k)(2).
[13] NCUA regulations define a "new" credit union as one that has been
in operation for less than 10 years and has less than $10 million in
total assets. 12 C.F.R. §702.301 (2004). Because of the relatively
small number of "new" credit unions, this report does not focus on
them. NCUA defines a credit union as "complex" when its total assets at
the end of a quarter exceed $10 million and its risk-based net worth
calculation exceeds 6 percent net worth. 12 C.F.R. §702.103 (2004).
[14] An earnings transfer means that a federally insured credit union
must increase the dollar amount of its net worth quarterly either in
the current quarter, or on average over the current and three preceding
quarters, by an amount equivalent to at least 0.1 percent of its total
assets, and must quarterly transfer that amount (or more by choice)
from undivided earnings to its regular reserve account until it is
''well-capitalized.'' See 12 C.F.R. §702.201(a) (2004).
[15] Department of the Treasury, Comparing Credit Unions with Other
Depository Institutions (Washington, D.C., January 2001).
[16] See 67 Fed. Reg. 38431 (June 4 2002).
[17] See 67 Fed. Reg. 71113 (Nov. 29, 2002).
[18] The historical net worth criterion had two parts: (1) a credit
union would need a minimum net worth ratio of 5.50 percent as measured
using the quarter-end balance of total assets. If there was an
applicable RBNW requirement, the credit union's net worth ratio could
not be more than 50 basis points (0.50 percent) below the RBNW
requirement; and (2) for each of the 3 prior quarters, a credit union
would need to have achieved a net worth ratio of at least 6 percent. In
contrast to measuring current quarter net worth by quarter-end total
assets in (1) above, for each of the three prior quarters a credit
union could elect among any of the four methods of calculating the
total assets denominator of the net worth ratio. If that credit union
were subject to a RBNW requirement, it would also need to have met that
requirement in each of the 3 prior quarters. For the performance
criterion, NCUA proposed that for the current and each of the 3
preceding quarters, a credit union would need to have increased the
dollar amount of its net worth by a 60 basis point (0.60 percent)
annual return on average assets (ROAA). Finally, the proposed growth
criterion required that for the period combining the current and 3
preceding quarters, the credit union's ending total asset growth could
not exceed 110 percent of the growth in net worth plus shares and
deposits. See 67 Fed. Reg. 71113 (Nov. 29, 2002).
[19] The total risk based capital ratio is the sum of tier 1 capital
(core) and tier 2 capital (supplementary) divided by risk-weighted
assets. Tier 1 includes common stockholder's equity, retained earnings,
and noncumulative and limited amounts of cumulative perpetual preferred
stock. Tier 2 includes, among other supplementary capital elements, the
nontier 1 portion of cumulative perpetual preferred stock, limited-life
preferred stock and subordinated debt, and loan loss reserves up to
certain limits. See Department of the Treasury, Comparing Credit Unions
with Other Depository Institutions (Washington, D.C., January 2001).
See also Department of the Treasury, Credit Unions (Washington, D.C.,
December 1997).
[20] Id.
[21] See 68 Fed. Reg. 32958 (June 3, 2003); see also 12 C.F.R.
§703.14(b) (2004).
[22] In this report, we refer to corporate credit unions' additional
forms of capital as secondary capital per the NCUA description.
[23] Unrated subordinated debt has not been evaluated by a rating
agency for risk--that is, probability of full repayment. Private
placement is a sale directly to an institutional investor.
[24] See James A. Wilcox, "Subordinated Debt for Credit Unions"
(prepared for the Filene Research Institute and The Center for Credit
Union Research, 2002).
[25] A credit union may be designated by NCUA as a low income credit
union if it serves predominantly low-income members, a category that
includes members who either earn less than 80 percent of the average
for all wage earners as established by the Bureau of Labor Statistics,
or have annual household income that falls at or below 80 percent of
the median household income for the nation. The term "low income" also
includes members who are full-time or part-time students in a college,
university, high school, or vocational school. See 12 C.F.R. §701.34
(2004).
[26] NCUA regulations also specify the conditions under which low
income credit unions can receive secondary capital accounts. For
example, the maturity of the secondary capital account must be for a
minimum of five years and must not be redeemable prior to maturity. See
12 C.F.R. §701.34(b).
[27] The CRA requires all federal bank and thrift regulators to
encourage depository institutions under their jurisdiction to help meet
the credit needs of the local communities in which they are chartered,
consistent with safe and sound operations. See 12 U.S.C. §§2901, 2903,
and 2906 (2000). CRA requires that the appropriate federal supervisory
authority assess the institution's record of meeting the credit needs
of its entire community, including low-and moderate-income areas.
Federal bank and thrift regulators perform what are commonly known as
CRA examinations to evaluate services to low-and moderate-income
neighborhoods. Assessment areas, also called delineated areas,
represent the communities for which the regulators are to evaluate an
institution's CRA performance.
[28] Corporate credit unions provide credit unions with services,
investment opportunities, loans, and other forms of credit should the
credit unions face liquidity problems. See 12 C.F.R. Part 704 (2004).
[29] 12 C.F.R. §704.2. Under this regulation, membership capital means
funds contributed by members that (1) have an adjustable balance with a
minimum withdrawal notice of 3 years or are term certificates with a
minimum term of 3 years, (2) are available to cover losses that exceed
retained earnings and paid-in capital, (3) are not insured by NCUSIF or
other share or deposit insurers, and (4) cannot be pledged against
borrowings. Paid-in capital encompasses accounts or other interests of
a corporate credit union that (1) are perpetual, noncumulative dividend
accounts, (2) are available to cover losses that exceed retained
earnings, (3) are not insured by NCUSIF or other share or deposit
insurers, and (4) cannot be pledged against borrowings.
[30] 12 U.S.C. §1831o(c)(1). The minimum leverage ratio is a
requirement that tier 1 capital be equal to a certain percentage of
total assets, regardless of the type and riskiness of the assets.
[31] Liquidity risk is the potential for financial losses due to the
inability of an institution to meet its obligations on time because of
an inability to liquidate assets or obtain adequate funding, such as
might occur if most depositors or other creditors were to withdraw
their funds from an institution. Operational risk is the potential for
unexpected financial losses due to inadequate information systems,
operational problems, breaches in internal controls, or fraud.
[32] Interest-rate risk is the risk of potential loss arising from
changes in interest rates. It exists in traditional banking activities,
such as deposit taking and loan provision, as well as in securities and
derivatives activities. Concentration risk exists if a bank is heavily
exposed to certain sectors or countries. It deals with the risks of not
diversifying assets so that a problem in any one sector or country
might financially affect the bank.
[33] 12 U.S.C. §1831o(c)3. The tangible equity ratio is the sum of
common stock, surplus, and retained earnings, net of Treasury stock and
currency translation adjustments, with intangible assets subtracted
from both the numerator and denominator.
[34] For additional information on bank capital components and bank
risk-based capital regulations, see U.S. General Accounting Office,
Risk-Based Capital: Regulatory and Industry Approaches to Capital and
Risk, GAO/GGD-98-153 (Washington, D.C.: July 20, 1998).
[35] See e.g. Federal Reserve Board Regulation H, 12 C.F.R. Part 208,
App. A, E; Office of the Comptroller of the Currency regulations, 12
C.F.R. Part 3, App. A, B; Federal Deposit Insurance Corporation (FDIC)
regulations, 12 C.F.R. Part 325, App. A, C. Credit risk is the
potential for financial loss resulting from the failure of a borrower
or counterparty to perform on an obligation. Market risk is the
potential for financial losses due to the increase or decrease in the
value or price of an asset resulting from broad movements in prices,
such as interest rates, commodity prices, stock prices, or the relative
value of currencies (foreign exchange).
[36] Derivatives are financial products that enable risk to be shifted
from one entity to another. An off-balance sheet item is a financial
contract that can create credit losses for the bank but that is not
reported on the balance sheet under standard accounting practices. An
example of such an off-balance sheet position is a letter of credit or
an unused line of credit that commits the bank to making a loan in the
future that would be on the balance sheet and thus create a credit
risk.
[37] To be considered a significant exposure, this gross market risk
exposure must exceed 10 percent of total assets or exceed $1 billion.
[38] NCUA Form 5300. Available from www.ncua.gov.
[39] NCUA defines a credit union as "complex" when its total assets at
the end of a quarter exceed $10 million and its risk-based net worth
calculation exceeds 6 percent net worth. 12 C.F.R. §702.103.
[40] NCUA's November 2000 report notes that the "risk portfolios" of
balance sheet assets consist of long-term real estate loans, member
business loans outstanding, investments, low-risk assets, and average-
risk assets. The "risk portfolios" of off-balance sheet assets are
loans sold with recourse and unused member business loan commitments.
[41] A credit union may substitute one or more alternative components,
in place of the corresponding standard components in 12 C.F.R.
§702.106, when any alternative component amount, expressed as a
percentage of the credit union's quarter-end total assets as reflected
in its most recent call report, rounded to two decimal places, is
smaller.
[42] 12 C.F.R. §702.107 (2004).
[43] The majority of these failures have occurred during the latter
part of 2003.
[44] H.R. 3579--Credit Union Regulatory Improvements Act of 2003.
[45] Two-phased refers to the current PCA system of required net worth
ratio for most credit unions and an additional risk-based computation
required for complex credit unions.
[46] Prior to CUMAA, although credit unions were not subject to an
explicit net worth requirement, they were required to make transfers to
a regular reserve account based on the current ratio of their regular
reserves to risk assets.
[47] The risk weights for the four categories in the Basel Accord
assume all assets within each category have the same level of credit
risk.
[48] We did not perform an evaluation or assessment of the items
provided by NCUA. Appendix I provides additional details on our scope
and methodology.
[49] Regulators use the CAMEL (capital adequacy, asset management,
earnings, and liquidity) system to rate depository institutions on a
scale of 1-5: 1 is strong, 2 is satisfactory, 3 is flawed, 4 is poor,
and 5 is unsatisfactory.
[50] The parity provision in Credit Union Membership Access Act of 1998
(CUMAA) states that, in general, if the federal banking agencies
increase or decrease the required minimum level for the leverage limit
(as those terms are used in section 38 of Federal Deposit Insurance
Corporation Improvement Act of 1991), the NCUA board may, by
regulation, and subject to the determinations set forth in CUMAA
section 301(c)(2), correspondingly increase or decrease one or more of
the PCA net worth ratios. See 12 U.S.C. §1790d(c)(2).
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